Pay/Collect Interest

It is very unlikely that your business will not have to take out loans to buy assets and other major purchases. When you do, you are required to pay interest on it, which counts as an expense, to whoever you owe the money to.

You may also choose to loan money to others to profit on the interest. Note that a savings account with a bank would fall under this category because you earn interest profit from the bank.

Regardless or whether you loan money from someone or whether you loan money for someone, there are two types of interest you need to consider.

• Simple Interest

  Here, the amount that you get for each period is fixed, based off a percentage of your initial loan/investment. So if you borrowed or loaned $10,000 for a certain period of time at 3% per month, then each month you would receive $300.00. In this scenario, the amount of interest remains fixed per fixed period of time.

  To find the total amount to pay/earn for the period of the loan, just find the amount you get per pay period (the interest computed from the initial investment), by the total number of pay periods during the loan.

• Compound Interest

  Here, the amount that you get from interest is further compounded from what you continue to get through interest. This means that interest that you make from a pay period is compounded into your initial loan/investment, and the next pay period the interest is computed from both the initial investment as well as currently compounded interest combined.

  For now, I will show you how to find the total amount of the initial amount + compounded interest, because it is easier to do this than to compute just the value of the compounded interest on its own. To find just the interest earned/owed, just subtract this total from the initial investment.

  Note that if I compute the interest and add this to the original amount (say initial investment of $10,000.00, with 3% compound interest monthly):

  • End of First Month

    Note that if we start with an initial investment of $10,000, and apply a 3% interest rate, the total can be written as:

    = $10,000 + ($10,000 × 0.03)

    Notice that this is equal to:

    = ($10,000 × 1) + ($10,000 × 0.03)

    Now, I can factor out the $10,000 term, leaving us with:

    = $10,000 × (1 + 0.03)

    Adding up the second term gives:

    = $10,000 × 1.03

    Which is the total amount of money after the first month.

  • End of Second Month

    Note at the end of the second month, we are applying interest to both the initial investment as well as the interest compounded so far. From the previous section, it is clear this is equal to $10,000 × 1.03.

    If we apply the same procedure as mentioned above:

    = (initial investment + compounded interest) + (initial investment + compounded interest) × (interest rate)

    By using the data above, this becomes:

    = ($10,000 × 1.03) + ($10,000 × 1.03) × 0.03

    Again, we can rewrite this as:

    = (($10,000 × 1.03) × 1 ) + ($10,000 × 1.03) × 0.03

    We can again factor out the investment amount before applying interest from the end of the second month, giving:

    = ($10,000 × 1.03) × (1 + 0.03)

    = ($10,000 × 1.03) × 1.03

    By consolidating terms, we get:

    = $10,000 × 1.03²

  • End of Third Month

    Now let us try this procedure for the end of the third month

    = (initial investment + compounded interest) + (initial investment + compounded interest) × (interest rate)

    By using the data above, this becomes:

    = ($10,000 × 1.03²) + ($10,000 × 1.03²) × 0.03

    Again, I can factor out the $10,000 × 1.03² term, leaving me with:

    = ($10,000 × 1.03²) × (1 + 0.03)

    = ($10,000 × 1.03²) × 1.03

    Again, consolidataing everything, we will get:

    = $10,000 × 1.03³

  • End of the n^th Month

    At this point you can clearly see a pattern. It appears to be:

    = $10,000 × 1.03ⁿ

    Where n is the number of months that have passed.

    Note that if you want to find out purely the amount you earned/owe for interest, just subtract the value above from the intial investment. In the case above, at the end of the third month, this is just:

    = $10,000 × 1.03³ − $10,000 = $927.27.

  Thus, it makes sense that the general formula for total amount of money is:

  (initial investment) × (1 + (interest rate))ⁿ, where n is the number of pay periods that have elapsed on the loan.

  Of course, if you wish to just determine the profit from interest alone, subtract the value above by the initial investment, as described above.

In general, it is best to find compound interest accounts for when you are loaning out money, and simple interest for when your are borrowing money. Be wary in your calculations of how many times you are paid per year, as that will affect the amount of money you get back from compound interest.

Interest Income

Money that you earned from interest will go under the revenue account Interest Income. Note that most likely you will not have to calculate the interest earned via simple or compound interest as the bank will most likely do it for you in your monthly bank statement. Be sure to update your accounts when you receive your bank statements, so everything matches up.

Interest Expense

When you borrow money, these can be described as either short-term loans or long-term loans. Examples of short-term loans are credit card loans and line-of-credit bank loans. Long-term loans may include mortgages on property or a long-term car loan, or anything that will be there for over a year.

Short-term Debt

Again, short-term debt is debt that is only around for 12 months or less. Any interest paid will go into an Interest Expense account.

Usually, you do not have to calculate the interest due as your bank will do it for you via a statement. In general, there are two types of short-term loans: credit card loans and bank line-of-credit loans.

• Credit Card Loans

  It is helpful that the bank will send you a credit card statement monthly. This statement will show you your new charges, the amount you have to pay to avoid interest payments, and the amount of interest currently charged on your unpaid balance.

  Note that if you do not want to or are unable to pay off your credit card bill, the interest on it will grow very fast, as it is compounded daily. Furthermore, if you decide to take a cash advance on your credit card, the interest starts compounding immediately.

  As well, for many credit cards, if you already have a owed balance, new purchases will have interest charged on them immediately, while some other credit card companies may give you a 20-30 day grace period. Also, pay attention to any fees for cash advances on top of the interest, as it may add up quickly.

• Bank Line-of-Credit Loans

  As a business owner, you can get lower interest rates on a bank line-of-credit than on a credit card. Typically, you would first make the purchase on credit, and if you cannot pay it off, you would move the purchase on to your line-of-credit. This has the side benefit of freeing up the amount you owe on your credit card, allowing you to make more large purchases, as credit cards typically have a spending balance limit.

  When you first borrow the money, you debit your asset to reflect increase in capital, and credit a liabliity account called Bank Line-of-Credit, as you are also adding more to what you owe.

  Date	Post	Debit	Credit
  Aug 22	Bank (1010)	1,000.00
  	Bank Line-of-Credit (2900)		1,000.00
  	Borrowed $1,000 from bank with Line-of-Credit.

  When you begin to pay back the loan, you need to deduct the bank loan, as well as add an interest expense, as a portion of what you pay will go to that.

  Date	Post	Debit	Credit
  Aug 22	Bank Line-of-Credit (2900)	250.00
  	Interest Expense (5800)	50.00
  	Bank (1010)		300.00
  	Paid off a portion of my Line-of-Credit.

  Notice here that you are paying $300.00 from Bank (as it is being credited), of which $250.00 of it goes to paying off the Bank Line-of-Credit, while $50.00 goes towards the interest expense payment.

Long-term debt

These debts refer to those that exist for longer than 12 months. These can include mortgages, car loans, and promissory notes. A promissary note is written agreement stating the principal to pay back, as well as the amount of interest and how the interest is applied to the loan (weekly, monthly, yearly, etc.).

Note that when you borrow money for long-term debt, it goes into a liability account called Notes Payable. Just like with short-term debt, you would apply the journal entries in the same fashion as shown below:

When you are dealing with long-term assets, you should move required payments within 12 months to the Current Liabilities section. While GridTracks does not distinguish between current and long-term liabilities, make sure the account IDs of all current liabilites is lower than that of all long-term liablilites, as GridTracks sorts all accounts by account ID, including in the balance sheet and income statement.

Long-Term Loan Amortization

Often for long-term loans, you will not be supplied with the breakdown of all the payments required on the loan. This is why it is important to separate payments towards principal vs. payments to interest, as interest payments start off high as principal is high, but as you pay off the principal; the interest payments will begin to decrease.

You can either look online for a amortization calculator, or you can do it yourself in a spreadsheet application.

Next Steps

• Finalizing Data
• Viewing Summary Data (Balance Sheet, Income Statement)
• End-of-Period Preparations

Credits

Please note that most of the information from this site is taken from the book "Bookkeeping for Canadians for dummies" by Lita Epstein and Cécile Laurin.

(Epstein, L., & Laurin, C. (2019). Bookkeeping For Canadians For Dummies. Hoboken, New Jersey: John Wiley & Sons, Inc.)